Stablecoins: What are they, and how do they work? (2024)

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• Stablecoins are digital assets that are designed to maintain a stable price over time.
• Stablecoins are often pegged to fiat currency, such as the US dollar, and backed by collateral.
• People primarily use stablecoins on DeFi platforms and to hold money within the crypto ecosystem.

While cryptocurrencies and the crypto ecosystem may present interesting and rewarding opportunities, many investors are cautious to invest in them due to their extremely volatile nature. But here's where stablecoins step in.

Stablecoins are another type of decentralized digital currency that can be bought and sold on the blockchain. However, these coins are pegged to real-world assets (such as fiat currency, gold, or US dollar bills) and are designed to be significantly less volatile than crypto.

Here's everything you need to know before investing in stablecoins.

What are stablecoins?

As the name implies, stablecoins are a type of digital currency that are designed to offer stability while benefitting from blockchain technology. They're often pegged (i.e., have a fixed exchange rate) to a fiat currency, such as the US dollar.

"In an ecosystem like cryptocurrencies, where volatility is typically high, this is an important property," says Paul Brody, principal and global blockchain leader at Ernst & Young. "If you want to take advantage of blockchain technology without exposing yourself to the volatility in crypto prices, this is the way to do it."

For example, one USD Coin (USDC) is intended to always be worth $1. While the dollar's purchasing power could change over time, it's much less volatile than cryptocurrencies.

There are also stablecoins that are pegged to a commodity, such as gold or oil, but fiat-pegged stablecoins are currently the most popular options.

The current most popular stablecoins are:

• Tether
• USD Coin
• Binance USD
• Dai
• TrueUSD
• Pax Dollar
• USDD

How do stablecoins work?

A stablecoin's pegged value is what makes it useful within the world of crypto. But that's possible only if coin holders can be assured they'll be able to cash out their stablecoins. To ensure this can happen, stablecoin creators hold onto reserves of other currencies or assets.

"This is called collateralization," explains Stephen Stonberg, strategic development officer at BH Principal Investments."Apart from being tied to another asset, collateralization also includes the buying and selling of affiliated assets through algorithmic mechanisms."

For instance, a stablecoin issuer may promise to hold $1 in a bank account for each of the cryptocurrency coins it creates. As long as the collateral (or reserves) are available, coin holders know that they'll be able to exchange a coin for $1. However, there's a risk that the stablecoin issuer doesn't actually have enough reserves.

Government agencies have discussed ways to regulate stablecoins, and have taken action against organizations that may have misrepresented their reserve holdings. And stablecoin issuers may share some details about what and where they're holding their reserves.

Still, if you're considering buying stablecoins, a lack of proper reserves is one potential risk to be aware of.

"In my view, the only really acceptable answer is with an independent audit," says Brody. "Not only do you need to know what assets are backing a particular token — if it's an asset-backed token — but you also need the assurance that those assets are not pledged against other liabilities."

Pros and cons of stablecoins

Although stablecoins are a type of decentralized currency, they have a more centralized structure. They are less risky than cryptocurrencies (which are constantly fluctuating in value) but still have the benefits of operating on blockchain technology. This results in stablecoins being significantly less volatile.

However, stablecoins are still susceptible to de-pegging or peg failures. Algorithmic stablecoins use an algorithm to get as close as possible to their desired peg value and adjust as needed with the market. But like other investments, a falling economy or market can significantly impact a coin's value, as many of them are tied in with traditional financial institutions.

Stablecoin collateral

Stablecoin issuers can choose how they want to hold the collateral for their stablecoins in reserves. The specifics vary depending on the stablecoin, but most fall into three categories:

Asset-backed collateral (Off-chain)

Asset-backed stablecoins maintain reserves in non-blockchain assets. The safest options may be those that hold fiat currency in regulated accounts. But some may hold commodities, such as gold, in reserve. Or some keep part of the funds in fiat currencies and invest the rest of the collateral.

"There's a bit more risk here because major price changes in those assets could threaten the ability of token-holders to cash out," says Brody.

Crypto-backed collateral (On-chain)

Crypto-backed stablecoins use cryptocurrencies as collateral. You can deposit and lock other cryptocurrencies to create these stablecoins, and they're generally over-collateralized to account for volatility. For instance, the stablecoin DAI is pegged to the USD (one DAI equals $1). But you could have to lock up $150 worth of ether (ETH) to create $100 worth of DAI.

"Another variation of stablecoins are on-shore and off-shore stablecoins," says Stonberg, a reference to whether the stablecoin issuers keep the reserves within or outside the US, which could impact regulatory oversight. "Ultimately, there will be a market for both types of stablecoins."

Algorithmic stablecoins

There's another type of stablecoin that doesn't have any collateral. Instead, it uses automated algorithms to try to create or decrease supply and hold a steady price. However, these algorithmic or "seigniorage-style" stablecoins haven't caught on.

How to use stablecoins

Stablecoins are primarily used in two ways:

First, you might want to keep money in the cryptocurrency system, but you don't think it makes sense to invest in bitcoin (or a different cryptocurrency) right now. Holding the funds in a stablecoin could limit your risk. It's a bit like keeping cash in a brokerage account while waiting to make an investment.

The other and perhaps more popular way that people use stablecoins is to participate in decentralized finance (DeFi) projects, such as crypto lending and borrowing platforms. Minimizing the volatility risk for users could make it easier to understand the cost (or profit) that can come from these transactions.

"For most companies and individual users, the ability to use stablecoins to manage risk while accessing DeFi and other online services is going to be the key value proposition and it's certainly what our enterprise users are interested in," says Brody.

Should you invest in stablecoins?

For individuals and institutions alike, stablecoins let people stay in the crypto world without the risk that's commonly associated with cryptocurrencies. In Stonberg's eyes, "what's unique and important about stablecoins is they represent the bridging of two worlds — cryptocurrencies and traditional finance."

However, if you're considering buying stablecoins or using them to lend or borrow money through a DeFi platform, know that there's still risk involved.

Asset-backed stablecoins might not actually hold enough assets to fully collateralize their outstanding coin balance. And even if they're over-collateralized, crypto-backed stablecoins could run into trouble if other cryptos experience major downswings.